House View: Q2 2017

A strong start to the year for emerging market equities

Corporate earnings continue to recover

Global politics remains a risk

Summary

The recovery in emerging markets has reasserted itself after a pause in the fourth quarter of 2016. The coincident recovery in global growth and a pick up in inflation have created an attractive backdrop for emerging markets and underlying corporate earnings. The significant valuation discount of emerging markets to developed markets remains excessive, particularly in an environment of resilient near-term growth.

Emerging market equity performance

2016 was a strong year for emerging market equities, as they gained just under 12 per cent on a total return basis in US dollars (Figure 1). After a period of consolidation in equity prices in the fourth quarter, this rally in emerging market equity prices has continued with a further 9 per cent gain to mid-March. As we have highlighted in the past, this positive return should be put in the context of prior years. The MSCI Emerging Markets Index was launched in 1988, and since then the average positive year has returned just over 40 per cent. With this in mind, the question rapidly focuses on the foundations of the recovery and its sustainability. For this we believe we need to look at valuations, the economic backdrop and, finally, politics.

Absolute and relative valuations

We have consistently highlighted that emerging market equities are materially undervalued. Compared to developed market equities since 2014, (and for this we use the MSCI World Index), they have consistently traded at a near 30 per cent discount (Figure 2). The recent recovery in emerging markets has been coincident with a recovery in earnings expectations that has outstripped that of developed markets. This means that an expectation of a reduction in the discount in valuation has not materialised. To put that in context, over the past 6 months expectations for 2017 earnings for developed markets have increased by 7 per cent, whilst for emerging markets that increase has been 12.5 per cent. Over that same period, developed markets have outperformed emerging markets by 1.3 per cent, further opening up the valuation gap.

The valuation of emerging markets compared to their recent history is perhaps one of the weakest links in this argument. They currently trade on 12 times next year’s earnings. This compares unfavourably with a 10-year average of 11 times and a 5-year average not far off that mark. However, developed markets trade at a 22 per cent premium to their 10-year average. But when we scratch beneath the surface, the picture is very different: developed markets, for example, trade on 16.7 times earnings, have a return on equity of 10.15 per cent and a yield of 2.5 per cent. Emerging markets have a similar but better return on equity of 10.6 per cent, a higher expected yield of 2.7 per cent and still trade on only 12 times earnings.

The earnings expectations for emerging markets (Figure 3), on which all these valuations assumptions are built, remain depressed. To put this in context, we can look at historic earnings for emerging markets. What becomes very clear is that 2016 earnings were less than 10 per cent ahead of those which were achieved in 2009 as the impact of the global financial crisis was felt across all markets. The 15 per cent growth in earnings expected for this year looks comparatively modest compared to the rebound of over 40 per cent we experienced in 2010. Should we take our lead from the ever-moving feast of analyst forecasts, clearly expectations for emerging market earnings are rising. This should be highly supportive of sentiment, valuations and, of course, equity prices.

Economicmomentum

The improvement in expectations and corporate earnings across emerging markets is clearly supported by an improvement in the economic backdrop. Countries such as Brazil and Russia, both of which experienced significant recessions over the past two years, have passed an inflection point. More important though is the clear change of priority in China. In the lead up to the Chinese domestic equity market correction in 2015 there was a focus on reform. This was embodied in the anticorruption push and targeted reductions in capacity and consolidation across the iron ore, coal and steel sectors. The cost of this, combined with the deceleration in credit growth, was, in our view, an unreported slowdown in GDP. In early 2016 growth clearly became the priority, credit growth re-accelerated and both property and infrastructure projects were rapidly approved. The Li Keqiang index (Figure 4), often derided as measuring only the historic drivers of Chinese economic activity, subsequently re-accelerated and has remained strong, suggesting that Chinese growth could even be running faster than the fastidiously reported 6.5 per cent to 7 per cent target range.

The importance of China and the strength of its growth cannot be under-estimated for emerging markets. Commodity prices have recovered strongly as Chinese demand has increased. This recovery in Chinese demand, combined with historically-loose global monetary policy, has been rapidly transmitted through to corporates in emerging markets. It is no coincidence that the emerging market Markit PMI (Figure 5), a measure of the health of the manufacturing sector, has recovered dramatically from the lows in late 2015 and early 2016.

We cannot mention China and the strength of its economic recovery without highlighting the over-hanging risk associated with its excessive and sustained credit growth. However, in the near term this should not detract from their positive contribution to growth. In our view, China’s near closed capital account and the upcoming national party congress in the fourth quarter makes this a mid – rather than short-term risk to emerging market equities. We therefore believe investors should be aware of the risks but still take advantage of the current strong support to earnings growth that Chinese policies provide in the near term.

Politics

The political backdrop for emerging markets is perhaps the aspect that has received most attention recently. While there are still specific issues with domestic politics in some emerging markets, these are outweighed by those major players - China, Brazil and India - where the news is more positive.

Unusually of more concern is the impact of developed market politics (Figure 6). While the uncertainties around upcoming European elections are unlikely to have any more lasting impact in emerging markets than the initial reaction to the Brexit vote, the US is more of an issue.

The potential destabilising effect of an introduction of trade tariffs and the cancellation or renegotiation of agreements such as NAFTA remains a concern, though one that we hope will be tempered by the knowledge that the integrated nature of global supply chains means punitive tariffs would not leave the US unscathed.

Conclusion

The strong start to 2017 for emerging market equities has the foundations to continue in the near term. Corporate earnings are benefiting from a recovery in global growth. We remain concerned over the sustainability of Chinese credit growth but acknowledge that the authorities’ policies are highly supportive of both Chinese and emerging market growth. Valuations remain excessively cheap in both absolute and relative terms. While emerging markets behave, the main risk has now become the unpredicatable political backdrop in developed markets.

Important information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (Aviva Investors) as at 31 March 2017 Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Some of the information within this document is based upon Aviva Investors estimates.

Nothing in this document is intended to or should be construed as advice or recommendations of any nature. This document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment.

In the UK & Europe this document has been prepared and issued by Aviva Investors Global Services Limited, registered in England No.1151805. Registered Office: St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated in the U K by the Financial Conduct Authority. Contact us at Aviva Investors Global Services Limited, St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Telephone calls to Aviva Investors may be recorded for training or monitoring purposes.

In Singapore, this document is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited for distribution to institutional investors only. Please note that Aviva Investors Asia Pte. Limited does not provide any independent research or analysis in the Substance or preparation of this document. Recipients of this document are to contact Aviva Investors Asia Pte. Limited in respect of any matters arising from, or in connection with, this document. Aviva Investors Asia Pte. Limited, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and is an Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1 Raffles Quay, #27-13 South Tower, Singapore 048583.

In Taiwan, this document is being circulated by way of an arrangement with Aviva Investors Securities Investment Consulting Co., Ltd. for distribution to investment professionals only. Please note that Aviva Investors Securities Investment Consulting Co., Ltd., does not provide any independent research or analysis in the Substance or preparation of this document. Recipients of this document are to contact Aviva Investors Securities Investment Consulting Co., Ltd., in respect of any matters arising from, or in connection with, this document. Aviva Investors Securities Investment Consulting Co., Ltd., a company incorporated under the Company Law of the Republic of China with registration number 53097616, holds a valid Securities Investment Consulting Enterprise (SICE) License to carry out Securities Investment Consulting Service and other relevant business permitted by Financial Supervisory Commission, Executive Yuan, R.O.C. and provides permitted liaison and co-ordination services only. Registered Office: Room D-1, 24F, No. 7, Section 5, Xin Yi Road, Taipei 110, Taiwan.

In Australia, this document is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd for distribution to wholesale investors only. Please note that Aviva Investors Pacific Pty Ltd does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Pacific Pty Ltd in respect of any matters arising from, or in connection with, this document. Aviva Investors Pacific Pty Ltd, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business Address: Level 50, 120 Collins Street, Melbourne VIC 3000, Australia.

Will Ballard

Will is the lead portfolio manager responsible for our Emerging Markets and Asia Pacific equity strategies.

Experience and qualifications

Prior to joining Aviva Investors, Will worked at Royal Bank of Canada in their Global Arbitrage Trading division. Before this, he was a fund manager at Henderson Global Investors on their Pan European Equity Multi-strategy team.
Will holds an MA (Hons) from Cambridge University, He also holds the UKSIP, Investment Management Certificate and is a CFA® charter holder.